What's the big deal about banks refusing to lend?

Anybody--but especially frugal people--can be excused for thinking that the whole credit crisis thing is being overblown. After all, we get along without debt. In fact, we strongly recommend that others do so as well. If getting along without debt is the way to go, why make such a big deal over a credit crunch?

For an individual, there's a reasonable debt-free path to some sort of prosperity. You earn money, you spend less than you earn and save the difference. Over time you accumulate durable items that raise your standard of living for years to come; your income rises (as you become more skilled and prove yourself a reliable worker); you earn a return on your savings and investments.

So, what's the big deal? If everybody did that, we'd hardly need credit at all, and could just ignore credit squeezes. Right?

Consumer debt

That intuitive analysis really just covers consumer debt, which is not at the heart of the matter.

Consumer debt is a factor in the crisis, in that it has let people live beyond their means. That has produced an illusory boost to the economy, even as it has produced a shortage of savings. But a cut-off in consumer credit is not what people are worried about when they say that banks have quit lending (even thought it's enough all by itself to produce a recession, simply because consumers who had been borrowers will have to become net savers, if only because their access to credit has been cut off).

Productive debt

The shortage of credit that has everyone in a tizzy is credit used to buy productive assets. When a farmer borrows money to buy seed, that's productive debt. When a baker borrows money to buy a second oven, that's productive debt. When a huge utility borrows money to build a power plant or a water treatment facility, that's productive debt.

It's possible for farmers, businessmen, and giant corporations to get by without debt--but only as much smaller operations. So, there are two issues: the size of the enterprise, and the transition to being that size.

Enterprise size

WIthout access to debt, business size is limited by the amount of invested capital:

The farmer can't plant more seed than he can afford to pay cash for (after budgeting for fertilizer, fuel, and so on).

The baker finds himself turning away good customers because his one oven can only produce so much (until he saves up enough money to buy a second oven--something that might take years).

The utility can't expend to serve a growing population (except by retaining a decade's worth of profits).

This is not necessarily a bad deal for the business, if the enterprise is sized correctly. The baker with just one oven can only produce so much bread or pizza, so he only has to work so hard. Since demand is strong but supply is limited, it's possible to earn a good profit. You often see this sort of result in highly skilled crafts--a well-thought-of luthier might have an order book that extends out for months or even years.

When credit is available, this sort of situation doesn't develop, except for things like skilled crafts. Credit makes it possible for the business to expand. And if the business doesn't expand, competitors will move in to meet the demand.

When credit is tight, this sort of situation can persist for years (which can be very frustrating for customers, who can't buy what they want--because the guy who makes it is selling all he can produce to long-time customers).

Transition

Before we get to the tolerable (if sometimes frustrating) situation of businesses staying small even when there's strong demand, we have to get the businesses sized correctly. That can be terribly painful.

Many businesses are utterly dependent on ready access to credit. This is especially true of businesses with large capital demands, such as farms (where huge amounts of money are tied up in land and equipment) and utilities (where the capital takes the form of power plants, telephone switches, well fields, pumping stations, water towers, etc.), but it can be true of any business.

With much or all of their capital tied up in plant and equipment, the business uses credit to buy supplies and to meet payroll. If access to credit is lost, even for a couple of weeks, the business is no longer a going concern--invoices go unpaid and the payroll can't be met.

That's even true of a business that's not really operating on the edge. A successful farmer, for example, might have enough cash to finance his whole operation--buy seed, fertilizer, fuel, pay for maintenance, and so on--for a year. But suppose a poor crop this year leaves him with less cash next year. Unless he has access to credit, he can't make full use of his land and his equipment. If he's only able to plant and fertilize half his fields, he can easily enter a death spiral, never making enough money one year to make full productive use of his capital the next. In theory he could downsize the farm--selling some land, selling a big combine and buying a smaller one, etc.--but that sort of transformation is hard at the best of times and can easily be impossible in any particular year, especially if his neighbors are in much the same situation.

Other businesses face exactly the same sorts of issues--needing to sell equipment that they can't put to productive use because they lack the cash to buy raw materials, pay their employees and so on. But they too can't actually do so, because nobody else has the cash or the access to credit to buy the equipment.

Current situation

I mention all this because we're dangerously close to this situation now. Many businesses are unable to borrow. If this continues, they'll be forced to try to shrink--and many of those efforts will fail. Even where they succeed, the new business will be smaller--with fewer employees, less output, and lower profits. They (and their customers, and their suppliers) will all be buying less, meaning that other businesses--even ones that don't depend on credit--will have to shrink as well.

That's what a recession is, and this is shaping up to be just that.

For an individual, getting along without debt is a great idea--now more than ever. But for the economy as a whole, a credit crunch is hard on everybody.

What to do

Well, staying out of debt is a good start. Beyond that, it depends on how you make a living. Last year I wrote about preparing for a recession. That advice still holds, and it's not too late to prepare, even with recession staring us in the face.

If you're an employee, you're largely dependent on the success of your employer, and your employer's success will depend on its need for credit. If you have any visibility into that side of your employers operations, you can get a good sense as to how much risk a credit crunch poses. Note that being a great employee won't necessarily help in a situation like this. Many firms that lose access to credit will have to shrink by half or more, so plenty of highly productive employees will have to be let go.

As a special case of being an employee, if you work for something other than a business--federal, state or local government, a school or university, a charity, foundation, or similar non-profit--you may be in much better shape. Those sorts of institutions tend not to be dependent on debt to fund their day-to-day operations. They may see their income drop as charitable contributions and tax receipts drop--and they may well have to let employees go--but the aren't in the position of having to shrink their business instantly down to what can be funded on a cash basis. They're probably already there.

If you're a business owner, move as quickly as you can to get things on a cash basis. (I realize that this advice is coming rather late in the cycle.) If you've been using credit to bridge the gap between paying your suppliers and getting paid by your customers, this will admittedly require shrinking your business. There may not be time to wind things down gradually--you're probably better off immediately cutting whatever you can't afford without credit. A small business with one or a few employees is better than a medium-sized one with many employees, if the medium-sized one is in receivership.

If you're retired, the future is especially murky. The collapse of credit is hugely deflationary, and if that's all that happens, your cash and government bonds will do very well, and you'll come out of this in fine shape (unless you have too much of your retirement money in stocks). The bailout efforts, though, are largely inflationary. To the extent that they succeed, those stock investments may do okay, while the cash and bonds lose purchasing power to inflation. Worst case, we get enough inflation to destroy your dollar-denomonated investments without preventing the deflationary recession that wrecks your stocks, and then drives the economy down to the point where you can't get a job either. In that situation you have little choice but to opt out of the money economy all together. Let's hope it doesn't come to that.

No matter where you're starting from, though, recognize that these financial events affect production, but they don't affect productive capacity: The land is still there, the factories are still there, the equipment and workers are still there. Over time, things will work themselves out to put the productive capacity back into production.

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Suppose there's a farm. Six hundred forty acres of corn and soybeans, ready to harvest. Land owned free and clear--and the farmer also owns appropriate tractor and combine, debt free. However, the farmer has sunk every penny of cash he has into this year's crop.

Because the banks are afraid to lend to anybody, when he has a large unplanned expense due to a mechanical problem with the harvester, he tells his farmhand to take a few weeks off, and spends the money budgeted for payroll to buy parts.

Do you really think the farmer is bankrupt?

The fact is, lots of businesses are in that sort of situation. They have invested all their capital in productive assets. They didn't need to--they could have kept a large cash reserve that made borrowing money unnecessary--but then the business would have been smaller and less profitable. A business with assets of millions of dollars, that spins off profits of hundreds of of thousands of dollars a year, could nevertheless be in a position where a total lock-up of the credit markets can make it impossible for them to pay their bills. Under normal circumstances--even under most abnormal circumstances--credit is readily available because of their assets and profitability. But if the bank itself can't get credit (which is the case right now for far too many banks), they may not be able to lend.

Not bankrupt--except that a credit crisis might well spell the end of them.

As a freelancer and hopefully, soon, small business owner, this is the kind of issue that's in the back of my head at all times. For the most part I've preferred to earn and live and work within my means and I've managed to slowly but surely expand my business without having to resort to credit to upgrade my equipment (as an animator, that's pretty much just my computer and office supplies). Luckily I've been able to earn more with minimal upgrades because of my own increase in skill and productivity, plus just knowing better clients.

However, I've definitely hit points where I really wished I was able to sink money into expanding my business, which right now is localized in my apartment. It makes me look less attractive to higher profile clients who are incredulous at such a business' effectiveness, even if I have past results to show for it. I've had to turn down larger projects just because I needed more than one person to get it done, but I can't afford the overhead of even having a freelancer work on site (I'm not crazy about outsourcing or having someone telecommute for me).

Anyway, I guess I'll just be staying here as a self proprietor and build up my client base and savings, slowly but surely expanding until I (and the economy) reach a point in which borrowing is worthwhile again.

Avoiding debt is always the safer strategy, and during tough times it's also the winning strategy. During good times, though, taking on debt to expand is the winning strategy. So, it's important to know what sort of times you face.

@ Arvin: I think you're right, that now is the time for "slow but sure" expansion.

@ TheDepressingTruth: A business isn't a household; the optimal strategies differ. (Unless, of course, you're talking about a business so small that it essentially is your household.) The emergency fund for a household is to make sure a financial setback doesn't put you out on the street. Even the owner of a multi-million dollar business ought to have six month's expenses in a savings account or a money fund. But it would be silly for his business to have six month's spending sitting around in cash. (Even if right now it'd be pretty handy.)

Being nimble in business and personal finance is the name of the game. Although we can't be perfect by relying only on "productive credit," others that have an affect us may not. So it may destroy us, whether we are good or reckless about our credit.

Our first initiative is to build a personal financial plan, and than business one. As an entrepreneur, you want your business to succeed, but need to resist until you can adequately take care of yourself. Have an emergency savings plan and a good investment plan.

Although I see that it IS late in the game for some people to catch up, I do think that because most people run their business similar to how they run their household (frugally, credit-based, etc), and the small business owners that have not prepared for the future will be hurting, just as any other person who has not prepared. I don't wish it on them, I just think that it is a fact.

I don't understand this:

Even the owner of a multi-million dollar business ought to have six month's expenses in a savings account or a money fund. But it would be silly for his business to have six month's spending sitting around in cash.

I think that MOST wisely run businesses have 6 month's spending sitting in a savings account. And that is just as good as cash (for the time being). Whether you are a farmer or a CEO of a multi-faceted company, you should have that safety net. My grandparents on both sides ran successful farms, and neither believed in debt. Neither lost their minds when a crop year was particularly bad, and neither would be upset in today's "crisis".

That said, I do NOT believe that business are being turned away for credit at the rate the media leads us to believe. People who are not risky borrowers are buying cars on credit today, and buying houses. The risky borrowers are not able to, and maybe that is for their own benefit.

Also, I do not think that the small business owners and households are solely responsible for the mess in front of us. I believe that it is irresponsible spending on big business and government's part (which has been a long time coming) and I don't think that the "crisis" is as bad as they make it out to be. With the plan laid out by Dave Ramsey (http://www.daveramsey.com/media/pdf/the_common_sense_fix.pdf), there is no need for a bailout, and no need for mass hysteria like the nightly new (not you) tries to induce.

I'm sorry. This seems like the same tactics used by this administration to bring us into war ("they HAVE WMDS!!!! We have knowledge!!! We have to go over and stop them RIGHT NOW!!! vs. We will be in a LONG and HARD recession is we don't pass this bill RIGHT NOW!!! We can't wait!!!). I'm not buying it.

Wait - small business owners are the same people Obama will ladle extra taxes on when he becomes president. They are, after all, those with incomes in the range he's talking about. And, don't forget, he'll be raising the capital gains tax as well. That will do in the stock market.

When I said that this administration was pressuring us into this, I was not endorsing Obama. Just to be clear. The plan that I linked to earlier talks about ELIMINATING the capital gains tax, which I agree with.

I wasn't responding directly to your previous post. The point I was trying to make is that with more government intervention and meddling, the worse it will be.

I go along with your view on the Bush Admin. pushing this through using scare tactics. It was the Republicans, the conservatives, that scuttled the deal and made everyone slow down.

The democrats are true believers in big government as our saviors - not my viewpoint. So, while I don't trust the republicans because they've abandoned their philosophical principles long ago, I feel the democrat rise to power is going to add gasoline to the crisis.

I admit that most of what I know about the current state of the credit markets comes from either the mass media or from Wall Street types, both of whom may be inclined to make things sound worse than they are. (The journalists, because it makes for more interesting news; the Wall Street types, because it really is a crisis for them.)

So I can't swear that the current situation really is a severe credit crunch--I just don't know. But I can say that a severe credit crunch is really, really bad for everybody, not just people who are in debt.

Probably the biggest problem with businesses keeping large cash reserves (the way a household might) is that many businesses have huge cash flows relative to their profits. For example, they might have expenses of $1 million a month versus revenues of $1.05 million a month. They make a cool $600,000 a year in profits, but you want them to hold $6 million in cash reserves, just in case the money markets seize up? If they had that much money, they could open four or five new stores and multiply their profits.

A related reason that it's different for a household is that revenues aren't so connected to spending. It may be painful for a household to make large cuts in spending, but at least doing so doesn't cut income. Your job continues to pay the same salary even if you start brownbagging your lunch or turn off your cable. But buying less raw materals or laying off employees very quickly results in reduced output for the company--meaning a lower income.

Lending money is a buisness, and as you said in your article "This is not necessarily a bad deal for the business, if the enterprise is sized correctly." "Since demand is strong but supply is limited, it's possible to earn a good profit".
I think smaller lending institutions will step up and fill the void left by the death of the behemoth banks/lending institutions. When the dinosaurs bit the big one, a small mammael was given an opportunity....the rest is history.

I'm sure it would happen. The only question is how long it would take. It's been a couple hundred million years and we still don't have land mammals as big as the biggest dinosaurs. Of course, size is not an absolute good, but certain things are only possible once an entity reaches a certain size.

@Kav:"I wasn't responding directly to your previous post. The point I was trying to make is that with more government intervention and meddling, the worse it will be."

...because the almost unprecedented lack of regulation the past several years has been so good for the economy and the country? With Wall Street successfully demonstrating that it can handle the lack of regulation responsibly?

Banks are in the business to lend money, large or small, they must lend money, other industries lend money also like insurance companies, union pension funds, investment banks, etc., the only question is how much and at what interest rate. Banks will lend money to farmers if they are a good risk same with utility companies, which by the way can issue bonds just like large corporations, that's how banks make money it just might not be at 6 or 7%, but maybe at 9 or 10% you can get money. Home loans use to be 18% at one time, and now a good risk borrower can still get a loan for 6%, it all about risk for the lender which will determine what business or person gets a loan.

The big deal is that the dollar will continue to decline in value and eventually become worthless thanks to the fractional reserve banking we are subjected to. We've propped up approx. 300 million people on a false economy that will inevitably collapse. Just because business can grow faster by borrowing money doesn't make it a good thing.

I'm unemployed, I'm an IT project manager by trade. Businesses tend to borrow money to upgrade their IT infrastructures.

I have a son who is a recent college graduate. He appears poised to get his first "real job". His problem will be transportation. How does he borrow money to buy a car?

My daughter (in HS) works for a local business. They depend upon credit to manage their cashflow. If she looses the job because of the the current crisis (very possible), I loose because her expenses become my expenses......

I hear what you are saying but again, just because credit is available doesn't make it a good decision. I don't know where your son lives, but perhaps there's public transportation available? Perhaps he's close enough to work that he could buy a bike or walk? Perhaps there's another co-worker in his area that he could share a ride with?

People used to work together to solve problems. Farmers used to have children to help with the work. If they couldn't afford equipment they would work with other farmers to pay for it, and share it. Now children are a tax write off because they are a burden and provide no "value" to a household. I hope you know what I mean by that.

By relying on credit we've only set ourselves up for major disaster. Look at all the programs that have been cut in schools because there is no budget. How many people know how to work on a car, fix a house, or plant a garden? We've taken things like this for granted and never asked ourselves what we'd do if the bottom falls out. Sure we can look this stuff up on the internet, but what will we do when the power companies don't have the money to run their machines?

I'm not trying to make a lecture here, as I too fear that I won't be able to provide for my family if our economy collapses. I have a mortgage, car loan, and student loan. Without this credit I certainly wouldn't have these things. However knowing what I know now, that these loans are at the expense of future generations, I can't in good consience want to continue participating in this system. Each generation gets further and further into debt while all the wealth gets directed to a select few.

Oh, I'm staying out of debt--I think it's always a sensible decision for households, and especially so now.

But a credit crunch hurts everybody, including sensible households. That's my main point. (Also, although the pain hits various places harder than others, it doesn't reliably hit the guilty any harder than it hits the innocent, so there's not as much satisfaction as there might be in gloating while the economy rolls over the careless and imprudent.)

Are you familiar with fractional reserve banking? If so, do you approve of the practice? Now that I know more about it, I don't. The money supply is constantly increasing which means the purchasing power of the dollar gets smaller and smaller. Wages are not increased at the same rate as inflation, and consider those that are retired and no longer have a source of income. Our savings are being eaten by this inflation.

Why is it that the cost of a house is tens of thousands of dollars more today than years ago? Did the value go up or did the market adjust to the amount of money in circulation? Imagine if you managed to save $1,000 about twenty years ago. It probably would have purchased quite a bit. Now imagine if you saved that money until today. Won't go very far, will it?

Speaking of housing. The government's borrowing from the federal reserve is limited by it's assets, like say gold. If you've stretched yourself to the limit and need more assets to borrow against, what's a good option? How about taking ownership of half the nation's houses?

In the interests of full disclosure, I should mention that I have an undergraduate degree in economics, and that "money and banking" was my favorite course.

With that in mind, I've got no problem with fractional reserve banking (as long as what's going on is open and above-board).

I'm actually kind of peeved with the arguments against fractional reserve banking, because I think that the policy prescriptions that fractional reserve banking detractors come up with are good; I don't see why they want to hang them on their weird opposition to fractional reserve banking.

We know what happens if the money supply remains relatively fixed as the economy grows--deflation. If that happens in a very modest way (as it did several different times when the gold standard was in effect--anytime the mining of new gold didn't keep up with the growth in the economy), it can actually be a kind of pleasant situation (at least for people with little or no debt)--your money is worth a little more every year, growth occurs at a calm comfortable pace, and bubbles are unlikely. Often, though, a static money supply isn't so benign. Deflation often produces results in a steady transfer of wealth from the poor to the rich (because the rich already have money, and the money is becoming more valuable relative to other things).

In the days of the gold standard things worked pretty well, as long as the productivity of the worlds mines happened to roughly match the productivity of the rest of the economy. When the supply of gold grew faster than the rest of the economy (as when the new world gold flowed into Europe) the result was inflation and instability. When the supply of gold grew slower, the resut was grinding poverty for all but the wealthy.

Modern central banking tries to address this by having "experts" arrange for the money supply grow at about the same speed as the economy. They did a crappy job in the 1970s (producing quite a bit of inflation). They did an okay job in the 1980s. In the late 1990s and early 2000s, though, the Federal Reserve screwed up big time, largely because Greenspan focused too much on a narrow view of prices--figuring that as long as consumer prices weren't going up too fast, he must not be producing too much money. We now know that the extra money flowed into financial and real estate assets, because consumer prices were being held down by globalization.

You won't find me saying anything good about inflation--it's just about the most pernicious force in an economy, destroying value everywhere. (War is worse. Nothing else comes to mind.)

Credit, on the other hand, is a good thing. I wrote a post a while ago called Good debt, bad debt. I think the financial markets are so volatile right now that I would advise anyone to be especially cautious about taking on more debt just at the moment, even for productive purposes, but I stand by that post in general.

I appreciate your thoughts on the matter. You touch on some very important points, specifically the idea that an economy must grow. Markets are based on human emotion and what we consider to be valuable. As the population increases, the various markets develop, and the supply of money increases (based on fractional reserves), you can obviously see that there eventuallly are an infinite number of things that must be considered when altering the money supply. Perhaps this is why all credit card transactions are now sent to the IRS, so they can better determine what the money supply should be? Anyway. Once our markets get to be so big, I don't think there is any way to maintain control. At least not with our current monetary system. Greed doesn't help either.

I haven't done enough research to get into a debate on these matters, but I've been interested in looking into competing currencies or a sustained economy (I don't mean communism) as alternatives. Any thoughts?

The banks are still motivated to make loans, and as time passes, will want to start making profits again by making more loans. Business is self correcting. But less we forget, it took Japan (15 years ago) a very long time to self correct.

I know that if the money supply is too great, the cost of things goes up, a.k.a. inflation. I recently read somewhere (and unfortunately can't remember where!!) that when the government injects money into the system, that the USD actually gains against other world currency, at least temporarily (or maybe artificially?). Can you help explain this phenomenon?

Normally a larger money supply will lower the value of the dollar, simply through ordinary supply and demand.

However, since changing the money supply has other economic effects, there will be some circumstances when increasing the money supply makes the US a more attractive place to invest money. If that results in large numbers of foreigners wanting to buy dollars to invest in the US, it can end up pushing up the value of the dollar.

Just now the current economic crisis has made the US seem like a safer place to invest, attracting some "safe haven" flows into the US and forcing up the value of the dollar. I talk about that some in my most recent post:

If you think about it, "money" is a Federal Reserve Note(FRN)that must be borrowed into existence, either by government, or by business and individuals. They don't just pass the stuff out so we have something in our pockets when we go to the store.

The only sure way to have FRNs in circulation is government spending. The Federal Reserve is only too happy to lend the United States the amount of any number of bonds the government cares to present as collateral. When the government pays its bills, it pays by check. The receiver takes the check to a bank and exchanges it for FRNs. Whatever cash the receiver then spends, which circulates further, has thusly been borrowed into existence.

Likewise when businesses or individuals borrows money. FRNs, or checks representing FRNs, circulate as borrowed money. When the loans are paid back, FRNs or checks reprensenting FRNs return to the bank, where they are taken out of circulation.

Paid-back loans and no new loans equals no money in circulation. The economy grinds to a halt because there is no medium of exchanging goods and services except through barter. The car dealer does not care that you have 20 tons of wheat to exchange for a new car; he doesn't want wheat--he wants FRNs or a check representing FRNs. Why? He has bills to pay, too, and he can't pay if nobody wants the wheat he just accepted from you.

He doesn't sell you the car, which means he doesn't advertise, which means the sign company lays off two employees, which means the shoe store doesn't sell them shoes, which means the factory isn't moving it's manufactured shoes, which means another round of layoffs, reduced purchasing, etc., etc., ad infinitum, until everybody is sitting around with things to sell, with no FRNs to exchange them for.

That is why, if people want to borrow money and will be able to pay it back, banks should loan the money. The only reason they should not is if it is one of those individuals that just got laid off because banks would not loan his employer next month's payroll.